What Is Required for a Periodic Inventory System at Period End?

A periodic inventory system is an accounting method where inventory levels and the cost of goods sold (COGS) are determined at specific intervals, typically at the end of an accounting period. Unlike continuous tracking, the inventory account in the general ledger is not updated with every purchase or sale transaction. Instead, separate accounts, such as “Purchases,” record inventory acquisitions throughout the period.

This system requires specific actions at the end of each reporting cycle to accurately reflect the value of inventory on hand and the expense of goods sold. Businesses using this method must perform a physical count of their inventory to establish the ending balance, which is then used in financial calculations. The periodic system is often favored by smaller businesses or those with low-volume, inexpensive inventory due to its simplicity and lower implementation costs.

Conducting the Physical Inventory Count

Performing a physical inventory count is a fundamental requirement in a periodic inventory system. This manual count establishes the exact quantity of each item on hand at the end of the reporting period. It is indispensable for determining the ending inventory balance and subsequently calculating the cost of goods sold. Without an accurate physical count, financial statements would not reliably reflect the business’s assets or profitability.

Careful planning is necessary for an efficient physical inventory count. Businesses often schedule counts during off-peak hours or when operations can be temporarily halted to minimize disruption. Teams are assigned specific areas, and pre-numbered tags or sheets are used to maintain control and accountability.

During the count, each item is systematically counted. It is important to identify and segregate any damaged, obsolete, or unsellable inventory during this process. All inventory, including goods in transit or consigned items, must be properly accounted for.

After the initial count, reconciliation involves comparing counted quantities against interim records and investigating discrepancies. Recounts are performed for significant variances to verify accuracy before finalizing figures. The precision of this physical count directly influences the integrity of financial statements, impacting both the reported asset value of inventory and the cost of goods sold.

Applying Inventory Valuation Methods

Following the physical inventory count, a monetary value is assigned to the counted units. This process utilizes specific inventory valuation methods to determine the cost of ending inventory and the cost of goods sold. The choice of method impacts a company’s reported financial results, including profitability and asset values.

One common method is First-In, First-Out (FIFO), which assumes that the first units of inventory purchased are the first ones sold. Under FIFO, the ending inventory is valued using the cost of the most recently acquired goods. This method generally results in a higher ending inventory value and a lower cost of goods sold during periods of rising prices, leading to higher reported profits.

Another method is Last-In, First-Out (LIFO), which assumes that the last units of inventory purchased are the first ones sold. Consequently, the ending inventory under LIFO is valued at the cost of the oldest inventory available. In an inflationary environment, LIFO typically leads to a higher cost of goods sold and a lower ending inventory value, resulting in lower reported profits and potentially lower taxable income.

The Weighted-Average Cost method calculates an average cost for all goods available for sale during the period. This average cost is determined by dividing the total cost of goods available for sale by the total number of units available. This calculated average cost is then applied to both the units in ending inventory and the units sold. The weighted-average method tends to smooth out price fluctuations, resulting in inventory values and cost of goods sold figures that fall between those determined by FIFO and LIFO.

Calculating Cost of Goods Sold and Making Adjusting Entries

At the close of an accounting period, businesses using a periodic system calculate the Cost of Goods Sold (COGS). This calculation uses the formula: Beginning Inventory + Net Purchases – Ending Inventory. The ending inventory figure, determined through the physical count and chosen valuation method, is crucial for this calculation.

Net Purchases represent the total cost of inventory acquired during the period, adjusted for related activities. This figure includes the cost of purchases, plus any freight-in costs incurred to bring the goods to the business, minus purchase returns and allowances, and purchase discounts received. These temporary accounts accumulate the details of inventory transactions throughout the period.

To prepare financial statements, specific adjusting and closing entries are necessary. The existing balance in the inventory account, which reflects the prior period’s ending inventory, must be adjusted to reflect the current period’s physically counted and valued ending inventory. This adjustment ensures the balance sheet correctly reports the ending inventory as a current asset.

The temporary accounts related to purchases, such as Purchases, Freight-In, Purchase Returns and Allowances, and Purchase Discounts, are closed out at period end. These accounts are closed into the Cost of Goods Sold account to aggregate all costs related to goods available for sale. The final Cost of Goods Sold balance is then transferred to the Income Summary account to determine net income or loss for the period. These entries ensure that the income statement accurately presents the cost of goods sold as an expense.